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With little liquidity, volatility may linger

By
Ion Dan

July 23, 2015

In December 2014 we wrote about
our concernsour concernsour concerns
around increasing liquidity risk within the fixed income markets. Here we build on those comments, with a discussion of macro and micro liquidity, and a look at current conditions like the growing micro-liquidity stress in the U.S. Treasury market — the perceived safe haven for all investors.

The state of macro liquidity

Macro liquidity — or global aggregate monetary conditions — is the playing field of central banks. Macro liquidity is the result not only of the U.S. Federal Reserve's actions, but the actions of central banks around the world. When looking at the macro liquidity environment, it is important to consider not just major central banks' current monetary policies, but also to assess what the most likely changes to those positions will be in the coming 6–12 months.

From this point of view, the future for macro liquidity poses some troubles for investors. The Federal Reserve and the Bank of England are guiding toward a possible step back in monetary accommodation, while the Bank of Japan and the European Central Bank are stepping up balance sheet expansion.

Diverging central bank balance sheets (as a percentage of GDP)

Diverging central bank balance sheets (as a percentage of GDP)

Data: Bank for International Settlements

Gross domestic product is a measurement of the total market value of the goods and services produced by a nation's economy.

Implications for market liquidity

Implications for market liquidity

In April 2015, the International Monetary Fund was warning investors about the implications for market liquidity* as a result of changes in macro liquidity.

"As U.S. monetary policy normalizes, the temporary boost to market liquidity provided by monetary accommodation will ebb, revealing a changed capital market landscape. Without the buoyant liquidity provided by the Fed, the liquidity-inhibiting impact of regulatory changes, industry consolidation, and other secular factors will likely become more pronounced. Markets could be increasingly susceptible to episodes in which liquidity suddenly vanishes and volatility spikes. Two recent price disruptions — the Oct. 15, 2014, volatility in U.S. Treasurys and the Jan. 15, 2015, surge in the Swiss franc — involved an initial shock that was likely amplified by market makers’ withdrawal of liquidity support. Many of the factors responsible for lower market liquidity also appear to be exacerbating risk-on/risk-off market dynamics and increasing cross-asset correlations during times of market stress. These phenomena suggest that low market liquidity may act as a powerful amplifier of financial stability risks."

To the aforementioned episodes, we can now add the recent repricing in German bunds in terms of magnitude, velocity, and time frame. Yields rose from 0.07% on April 20 to 0.98% on June 10, quite an impressive move in just 37 trading sessions (data: Bloomberg).

*Market liquidity refers to the liquidity conditions in a single market, and how easily one can buy and sell assets in that market. Generally, the less liquidity, the more buying and selling creates volatility in a single market.

An impressive move in 10-year German yields

An impressive move in 10-year German yields

Data: Bloomberg.

German bunds, long considered a safe haven, experienced a notable drop in prices as investors became increasingly optimistic about economies around the world. The resulting yield expansion happened quickly. It was another example of limited liquidity having an outsized influence during a change in market sentiment.

With the deterioration in U.S. Treasury market depth, micro liquidity concerns arise

With the deterioration in U.S. Treasury market depth, micro liquidity concerns arise

Market liquidity also exists at the security level, and was the focus of concern, in our December
commentarycommentarycommentary. As dealer inventories have diminished in most fixed income sectors, it has become much more challenging to buy and sell large blocks of securities. This is now starting to impact U.S. Treasurys, the bastion of liquidity among all fixed income markets.

As risk appetites vacillate, Treasurys have become prone to significant price moves (gaps) in both directions — either when risk-on positions are unwound, or when investors want to reduce interest rate exposure. As such, volatility in Treasurys has been increasing (measured as the 52-week rolling standard deviation/average of 10-year Treasury yields).

Rates volatility has picked up

Rates volatility has picked up

As the uncertainty of the Fed rate hike draws nearer, implied volatility is perking up, not only in Treasurys but also in currencies (as represented by the Deutsche Bank Currency Volatility Index or CVIX). Equity volatility (represented by the CBOE Volatility Index® or VIX) has been more contained.

Relative to fixed income markets, equity markets are experiencing less volatility. Uncertainty about rate hikes is one factor, but constrained liquidity within fixed income markets has also become influential.

The table below illustrates how the returns of various markets are correlated to Treasury volatility. The MOVE index represents Merrill Lynch Option Volatility Estimate calculated as a yield curve weighted average of normalized implied volatilities on 1-month Treasury options. Over the last three years, all asset classes have become more correlated to Treasury volatility relative to how these asset classes were correlated to rates volatility over a longer time frame, such as the 10-year period.

last 3 yrs

last 5 yrs

last 10 yrs

U.S. Aggregate

-0.47

-0.39

-0.28

U.S. Credit

-0.46

-0.41

-0.39

U.S. IG Corp

-0.42

-0.39

-0.39

U.S. HY Corp

-0.43

-0.36

-0.32

U.S. HY loans

-0.31

-0.24

-0.24

U.S. MBS

-0.56

-0.46

-0.20

CMBS

-0.43

-0.43

-0.21

ABS

-0.48

-0.40

-0.21

EM Sov

-0.60

-0.44

-0.36

EM Corp

-0.50

-0.36

-0.32

Govt-re

-0.53

-0.44

-0.21

Treasurys

-0.37

-0.24

-0.08

SP500

-0.27

-0.25

-0.31

VIX

0.30

0.28

0.44

CVIX

0.49

0.49

0.46

CRB

-0.22

-0.24

-0.16

MOVE

1.00

1.00

1.00

One concern here is that volatility appears to be contagious, bleeding into multiple fixed income sectors. Volatility is challenging enough when it lingers within a contained space; it poses an even higher hurdle when it spreads to other corners of the markets.

Table created from Bloomberg and Barclays monthly data.

Is there a liquidity issue emerging in Treasurys?

Is there a liquidity issue emerging in Treasurys?

Market depth is shown below for 10-year Treasurys. Note the collapse in market depth during the financial crisis in 2008. Importantly, however, the frequency of these drops has increased significantly since 2009. Historically, market depth has ebbed and flowed with volatility. Surging volatility coincides with less depth, whereas stable markets tend to be deeper.

Data: J.P. Morgan.

Treasury trading volume remains robust

Treasury trading volume remains robust

Daily trading volumes of Treasurys remain robust at about $500 billion a day and the relative trading volume versus non-Treasury debt seems healthy.

Yet liquidity has grown tighter

Yet liquidity has grown tighter

However, average daily trading volumes adjusted by gross issuance, amount outstanding, and the level of MOVE further suggest that Treasury price discovery and liquidity are under pressure relative to the size of the market and implied volatility.

Market implications

Market implications

U.S. Treasurys have been the cornerstone of the financial system, as the safety asset of choice due to the depth of the market and its liquidity advantage. If that is falling due to market positioning and regulation, investors might demand a higher risk premium as compensation, which will filter through to other asset classes, potentially creating heightened volatility across the broader fixed income landscape.

This tendency toward higher volatility is troubling in and of itself, but we think it could be amplified as we move along in 2015. This is because markets will contend with additional volatility drivers that include:

continued mixed signals in U.S. economic data

increased concerns about political risks around the world

uncertainty about the timing of the Fed's tightening of credit.

Taken together, we believe these circumstances will put a premium on managing risk as we address the challenges to come. The specter of higher volatility will be folded into every step of our research process, as we seek to position our portfolios to accommodate the increased possibility of market dislocations.

*Market depth is measured in millions at a tight bid-ask spread. When the number decreases, it means that less size can be traded at a tight bid-ask.

Charts are for illustrative purposes only.

The views expressed represent the Manager's assessment of the market environment as of July 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 877 693-3546. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

Ion Dan biography

Ion Dan

Ion Dan is a member of the firm’s taxable fixed income portfolio management team, with primary responsibility for portfolio construction and strategic asset allocation. He is lead co-portfolio manager for the Absolute Return MBS strategy, and senior analyst and trader for agency mortgage-backed securities (MBS). Dan joined Macquarie Investment Management (MIM) in April 2011 as part of the firm’s integration of Macquarie Allegiance Capital, with responsibility for evaluating and trading agency MBS. Previously, he spent 10 years with Macquarie Allegiance, most recently as MBS sector manager and portfolio manager. Dan started his career as a junior options trader on the PCX Exchange. He earned bachelor’s degrees in both business administration and economics from the University of California at Berkeley.

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